{"id":2437,"date":"2023-08-14T20:07:03","date_gmt":"2023-08-14T14:37:03","guid":{"rendered":"https:\/\/www.thewallstreetschool.com\/blog\/?p=2437"},"modified":"2023-10-11T08:12:54","modified_gmt":"2023-10-11T02:42:54","slug":"how-financial-modelling-helps-in-business-decision-making-for-capital-budgeting-techniques-what-you-need-to-know","status":"publish","type":"post","link":"https:\/\/www.thewallstreetschool.com\/blog\/how-financial-modelling-helps-in-business-decision-making-for-capital-budgeting-techniques-what-you-need-to-know\/","title":{"rendered":"How Financial Modelling Helps in Business Decision making for Capital Budgeting Techniques &#8211; What You Need to Know"},"content":{"rendered":"<p><span style=\"font-weight: 400;\">One of the most persistent dilemmas that companies and businesses face these days is which project to invest in and how the resources must be allocated. Capital budgeting techniques can be used to assess the value of such investments and determine which one will have the highest impact on the company value as well as maximise shareholders\u2019 wealth.\u00a0<\/span><\/p>\n<h3><span style=\"font-weight: 400;\">What is Capital Budgeting?<\/span><\/h3>\n<p><span style=\"font-weight: 400;\">Capital budget is the process of determining and evaluating long-term investments that contribute toward wealth maximisation of shareholders. In other words, capital budgeting helps in deciding whether to accept or reject a project and will the investment be fruitful in future years.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Key Highlights:<\/span><\/p>\n<ul>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Contributes to decision making related to investment opportunities.<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Helps in the understanding of the effects of the investments on businesses and the risks involved in it.\u00a0\u00a0<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Widely used techniques of Capital Budgeting are:<\/span><\/li>\n<\/ul>\n<ol>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Net Present Value (NPV)<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Internal Rate of Return (IRR)<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Payback Period and Discounted Payback Method<\/span><\/li>\n<\/ol>\n<h3><span style=\"font-weight: 400;\">Components in Capital Budgeting<\/span><\/h3>\n<p><span style=\"font-weight: 400;\">There a mainly three aspects when it comes to capital budgeting fundamentals and the capital budgeting process:<\/span><i><\/i><\/p>\n<ul>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><i><span style=\"font-weight: 400;\">How much of initial investment is required?<\/span><\/i><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">Initial Investment = Cost of Fixed Assets + Installation Expenses &#8211; Sale of Old Assets + Tax on Capital Gain &#8211; Tax Savings on Capital Loss + Additional Working Capital\u00a0<\/span><i><\/i><\/p>\n<ul>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><i><span style=\"font-weight: 400;\">What will be the annual cash inflows?<\/span><\/i><\/li>\n<\/ul>\n<p><b>Method 1:<\/b><span style=\"font-weight: 400;\"> Subsequent Cash Inflows = Sale &#8211; Variable Expenses &#8211; Fixed Expenses &#8211; Depreciation &#8211; Tax + Depreciation &#8211; Capital Expenditure\u00a0<\/span><\/p>\n<p><b>Method 2:<\/b><span style=\"font-weight: 400;\"> Subsequent Cash Inflows = Net Profit + Depreciation + Interest (1- Tax Rate) &#8211; Capital Expenditure\u00a0<\/span><\/p>\n<ul>\n<li><em><span style=\"font-weight: 400;\">What is the terminal cash flow from the project? Or what is the residual value of the asset?<\/span><\/em><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">Terminal Cash Flow = Scrap of New Asset &#8211; Tax on Capital Gain + Tax Savings on Capital Loss + Working Capital\u00a0<\/span><\/p>\n<h3><span style=\"font-weight: 400;\">Main Capital Budgeting Evaluation Techniques: NPV, IRR, Payback &#8211; Using Excel Examples<\/span><\/h3>\n<p><span style=\"font-weight: 400;\">Capital budgeting has been a crucial part of financial modelling and is used to determine the value of projects in the coming years. We will understand some main techniques and their limitations along with examples when it comes to financial project evaluation.<\/span><span style=\"font-weight: 400;\"><br \/>\n<\/span><\/p>\n<ul>\n<li aria-level=\"1\"><b><i>Net Present Value (NPV):<\/i><\/b><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">This is a form of Discounted Cash Flow (DCF) technique, which can be derived by summation of present values of cash proceeds in each year minus the summation of present values of net cash outflows in each year.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">In formula, it can be represented as:\u00a0<\/span><\/p>\n<p><img fetchpriority=\"high\" decoding=\"async\" class=\"alignnone size-full wp-image-2445\" src=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image1.png\" alt=\"\" width=\"608\" height=\"122\" srcset=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image1.png 608w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image1-300x60.png 300w\" sizes=\"(max-width: 608px) 100vw, 608px\" \/><\/p>\n<p><span style=\"font-weight: 400;\">However, it can be tiring to use such lengthy formulas manually. That\u2019s where Excel comes to rescue. Microsoft Excel has an embedded formula for NPV to make our task easier.\u00a0<\/span><\/p>\n<p><img decoding=\"async\" class=\"alignnone size-full wp-image-2444\" src=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image3.png\" alt=\"\" width=\"231\" height=\"61\" \/><\/p>\n<p><span style=\"font-weight: 400;\">Let\u2019s take a look at an example:<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Suppose you are working in the financial planning and analysis department of DMart and they are planning to open two new stores. The management would like to know if this is financially possible or not. Here we will implement the NPV method to evaluate the viability:\u00a0<\/span><\/p>\n<p><img decoding=\"async\" class=\"alignnone size-large wp-image-2443\" src=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image2-1024x517.png\" alt=\"\" width=\"640\" height=\"323\" srcset=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image2-1024x517.png 1024w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image2-300x151.png 300w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image2-768x388.png 768w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image2.png 1036w\" sizes=\"(max-width: 640px) 100vw, 640px\" \/><\/p>\n<p><b># Net Cash Flow is Cash Inflow minus Cash Outflow.<\/b><\/p>\n<p><span style=\"font-weight: 400;\"># While computing NPV, we start from year 1 rather than year 0 and later add the initial investment.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The general rule while making a decision about the project using NPV is if:<\/span><\/p>\n<ul>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">NPV &gt; zero, accept the project.\u00a0<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">NPV &lt; zero, reject the project.<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">In case of multiple projects and limited resources, projects will be ranked according to NPV and the highest one will be prioritised.<\/span><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">NPV is not free from limitations:<\/span><\/p>\n<ul>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">It does not account for project size comparison. Initial investment in both the stores are significantly different, so the NPV would not justify the scale very well.\u00a0<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">The discount or interest rate assumption also affects the NPV significantly.\u00a0<\/span><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">At 5% and 3% interest rate, NPV changes by almost Rs. 38,147.<\/span><br \/>\n<b><i><\/i><\/b><\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-2442\" src=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image5.png\" alt=\"\" width=\"928\" height=\"190\" srcset=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image5.png 928w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image5-300x61.png 300w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image5-768x157.png 768w\" sizes=\"(max-width: 928px) 100vw, 928px\" \/><\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-2446\" src=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image4.png\" alt=\"\" width=\"850\" height=\"196\" srcset=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image4.png 850w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image4-300x69.png 300w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image4-768x177.png 768w\" sizes=\"(max-width: 850px) 100vw, 850px\" \/><\/p>\n<ul>\n<li aria-level=\"1\"><b><i>Internal Rate of Return (IRR)<\/i><\/b><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">The second DCF technique is the Internal Rate of Return. It is also known as yield on investment, marginal efficiency of capital, marginal productivity of capital, rate of return and so on. IRR is the rate of return that a project earns. In other words, IRR is the discount rate that equates the PV of the cash inflows to the initial investment and causes NPV to become zero.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Mathematically, IRR can be expressed as:<\/span><\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-2441\" src=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image7.png\" alt=\"\" width=\"354\" height=\"122\" srcset=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image7.png 354w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image7-300x103.png 300w\" sizes=\"(max-width: 354px) 100vw, 354px\" \/><\/p>\n<p><span style=\"font-weight: 400;\">Let\u2019s continue with our previous example:<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The rule for deciding the projects in case of IRR is that if:<\/span><\/p>\n<ul>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">IRR&gt; Discount rate, accept the project.\u00a0<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">IRR &lt; Discount rate, reject the project.<\/span><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">After computing the IRR, it can be observed that in both stores IRR is greater than the discount rates and even though NPV of Store 1 is greater than Store 2, IRR of Store 2 is greater than Store 1. Regardless, both of the projects should be accepted but in case the company cannot afford both projects i.e. they are mutually exclusive, a store with higher NPV will be chosen as it maximises shareholders\u2019 wealth. This is common occurrence when it comes to capital budgeting for multinational corporations.<\/span><\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-large wp-image-2440\" src=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image6-1024x566.png\" alt=\"\" width=\"640\" height=\"354\" srcset=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image6-1024x566.png 1024w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image6-300x166.png 300w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image6-768x425.png 768w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image6.png 1036w\" sizes=\"(max-width: 640px) 100vw, 640px\" \/><\/p>\n<p><span style=\"font-weight: 400;\">The limitations of IRR are:<\/span><\/p>\n<ul>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">It doesn&#8217;t give you dollar value and only provides percentages.<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">It doesn&#8217;t account for non-linear cash flows, i.e. net cash flows can be negative sometime.\u00a0\u00a0<\/span><\/li>\n<\/ul>\n<ol>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><b><i>Payback Period and Discounted Payback Period<\/i><\/b><\/li>\n<\/ol>\n<p><span style=\"font-weight: 400;\">Payback Period Method is one of the traditional methods of capital budgeting. This method evaluates the exact amount of time required for the company to recover its initial investment. In terms of formula Payback Period can be represented as:<\/span><\/p>\n<p><i><span style=\"font-weight: 400;\">Payback Period = Investment\/ Constant annual cash flow<\/span><\/i><\/p>\n<p><span style=\"font-weight: 400;\">For example, an investment of Rs. 50,000 in a plant is expected to produce cash flows of Rs.10,000 for 10 years,\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Payback Period = 50000\/10000= 5 years\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\"># Shorter the duration, the better it is considered for the investment.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">In Excel, we will first calculate cumulative cash flows. Using that we can figure out after how many years cash flows start turning positive as the payback period would be some time after the last negative cash flow. In case of Store 1, cumulative cash flows turned positive after year 3 so we use the formula:<\/span><\/p>\n<p><span style=\"font-weight: 400;\">\u00a03+ ABS(Year 3 Cumulative Cash Flow\/Net Cash Flow of Year 4)<\/span><\/p>\n<p><span style=\"font-weight: 400;\"># ABS function helps us to find out the payback fraction.\u00a0<\/span><\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-large wp-image-2439\" src=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image8-1024x612.png\" alt=\"\" width=\"640\" height=\"383\" srcset=\"https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image8-1024x612.png 1024w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image8-300x179.png 300w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image8-768x459.png 768w, https:\/\/www.thewallstreetschool.com\/blog\/wp-content\/uploads\/2023\/08\/image8.png 1038w\" sizes=\"(max-width: 640px) 100vw, 640px\" \/><\/p>\n<p><span style=\"font-weight: 400;\">Couple of drawbacks of this method are:<\/span><\/p>\n<ul>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">It does not account for time value of money\u00a0<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Only consider time and not other factors like profits.\u00a0<\/span><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">An alternative to this method is the Discounted Payback Period which considers the effect of time value. In this method, you just have to discount the Net Cash Flows and then continue to follow the process done in the Payback Period method.\u00a0\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Using all these measures, we would be able to allocate our funds accordingly. In case we are required to only choose one of the two stores, we would pick Store 1 which has a higher NPV.\u00a0<\/span><\/p>\n<h3><span style=\"font-weight: 400;\">Last Notes &#8211; Capital Budgeting Practices in India<\/span><\/h3>\n<p><span style=\"font-weight: 400;\">Capital Budgeting is widely used by the firms through multiple criteria of DCF and traditional methods. IRR and NPV are the most frequently used by private sectors, whereas Payback Period is mostly used by public sector companies. Capital budgeting decisions are taken by top management and are planned in advance. However, in some corporations investment proposals originated from plant level too. In recent times, with highly competitive markets, planning and budgeting has been a difficult task to perform. Unpredictable future cash flows, resulting from the increased volatility and competition seem to be major factors in capital budgeting decisions.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The WallStreet School\u2019s flagship program on Financial Modelling and Valuations covers extensive practical training on topics like capital budgeting and much more in detail. It provides you with real world Capital budgeting case studies, emerging trends in capital budgeting, discussions led by industry experts and intensive training to speed up your career progression besides providing placements in Equity research, Corporate Finance, Consulting and Investment Banking domains.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">If you are looking for a solid capital budgeting course or a financial modelling program, the <strong><a href=\"https:\/\/www.thewallstreetschool.com\/financial-modelling-certification-course\/\">Financial Modelling and Valuations program<\/a><\/strong> is the right fit for you. You will learn about essential topics such as investment analysis and decision-making, financial project evaluation, cash flow modelling, discounted cash flow techniques, NPV and IRR analysis, risk management in capital budgeting, strategic investment planning and all the important topics you will need to become a professional in financial modelling and capital budgeting.<\/span><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Capital budgeting techniques can be used to assess the value of such investments and determine which one will have the highest impact on the company value as well as maximise shareholders\u2019 wealth.\u00a0<\/p>\n","protected":false},"author":22,"featured_media":2450,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_uf_show_specific_survey":0,"_uf_disable_surveys":false,"footnotes":""},"categories":[5],"tags":[],"class_list":["post-2437","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-financial-modeling"],"_links":{"self":[{"href":"https:\/\/www.thewallstreetschool.com\/blog\/wp-json\/wp\/v2\/posts\/2437","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.thewallstreetschool.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.thewallstreetschool.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.thewallstreetschool.com\/blog\/wp-json\/wp\/v2\/users\/22"}],"replies":[{"embeddable":true,"href":"https:\/\/www.thewallstreetschool.com\/blog\/wp-json\/wp\/v2\/comments?post=2437"}],"version-history":[{"count":0,"href":"https:\/\/www.thewallstreetschool.com\/blog\/wp-json\/wp\/v2\/posts\/2437\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.thewallstreetschool.com\/blog\/wp-json\/wp\/v2\/media\/2450"}],"wp:attachment":[{"href":"https:\/\/www.thewallstreetschool.com\/blog\/wp-json\/wp\/v2\/media?parent=2437"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.thewallstreetschool.com\/blog\/wp-json\/wp\/v2\/categories?post=2437"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.thewallstreetschool.com\/blog\/wp-json\/wp\/v2\/tags?post=2437"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}